Is Herbalife a Pyramid Scheme or Not?

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Herbalife (NYSE: HLF) plummeted by more than 12% to $37.34 per share after CNBC reported that activist investor, Bill Ackman, CEO of Pershing Square Capital Management shorted the company and considered it a “pyramid scheme."

Last June, Jacob Wolinsky of ValueWalk reported that Bill Ackman wrote in his letter to investors the hedge fund “added an equity short position” to its portfolio, however; he did not mention the name of the company. Wolinsky noted it was rare for the fund to hold a short position because Ackman is known as a long only investor.

Kate Kelly of CNBC cited a source who revealed that Ackman spent more than a year researching Herbalife  According to source, the activist investor considers Herbalife as the most compelling short thesis he has “ever seen.” Months ago, Ackman stated that he has a “patriotic bet” and “the country is better off when the company goes bust.” 

On the other hand, Michael Johnson, CEO of Herbalife immediately refuted Ackman’s allegations against the company in an interview with CNBC. Johnson called Ackman’s move as “blatant market manipulation.”

According to Johnson, the issue is not about Herbalife business model, but it’s about Bill Ackman’s business model. He said, “This appears to be another attempt to illegally manipulate the market by a group of short sellers.” Johnson explained that an extraordinary number of puts on Herbalife shares would expire on Friday, which is considered a “significant event.”  The Herbalife CEO urged the SEC to investigate the issue to protect the rights of the investors. 

Herbalife practices a multilevel marketing (MLM) business model and it is a member of the Direct Selling Association  just like other companies  such as Avon Products (NYSE: AVP)  and Tupperware Brands.

Legitimate multilevel marketing companies concentrate on building and expanding their network to be able to sell more products to consumers. The distributors in the network generate their income primarily from selling products, and not from recruiting.

According to the Federal Trade Commission (FTC) Bureau of Consumer Protection, “If the money you make is based on your sales to the public, it may be a legitimate multilevel marketing plan. If the money you make is based on the number of people you recruit and your sales to them, it’s not. It’s a pyramid scheme. Pyramid schemes are illegal, and the vast majority of participants lose money.”

Bill Ackman’s Herbalife Pyramid Scheme Presentation

Ackman is certain that Herbalife is the “best managed pyramid scheme in the history of the world.” He supported his statement with a 334-page presentation about the company during the Sohn Investment Conference. He also confirmed that he shorted the shares of Herbalife, but he does not own options on the stock.

Ackman pointed out that Herbalife’s products particularly Formula 1, its top selling nutritional shake mix is unknown to consumers, but it has higher global retail sales than popular brands. According to him, Herbalife managed to sell more products than its competitors, not because of a lower price, advertisements, or better research & development, but because it bundles its products with a business opportunity.

According to him, Herbalife’s independent distributors earn profits primarily from recruiting not from selling products to retail customers. He cited a statement from the company's CEO Michael Johnson and CFO Rich Goudis that Herbalife's top distributors are recruiters. They earn more money because they receive additional recruiting rewards.

Based on the analysis of Ackman’s firm, a typical Herbalife distributor only earns a retail profit of $87 per month using the company’s retail sales report. The firm emphasized, “Herbalife’s inflated suggested retail prices for its products mask the fact that the recruiting rewards earned by distributers vastly exceed their retail profit.”

According to Ackman, Herbalife is not a typical MLM company because its top 1% distributors receive a larger share of total commissions (88%) from recruiting compared with other companies. Tupperware's total payout commission is only 49 percent, which is the average for the industy. 

Compared with Avon, Herbalife’s commission strategy is different in two ways. Avon only pays recruiting rewards on three levels and its royalties are descending while Herbalife pays a production bonus (infinity bonus) for recruiting 4 down lines or more, and its royalties are flat. Avon initiated the multi-level compensation plan as part of its restructuring plan in 2005 to boost its revenue & cut expenses. Avon is the largest direct selling company worldwide with well-known brands. Since 2007, its revenue increased from $9.9 billion to $11.30 billion last year.

He also pointed out that Herbalife exaggerated its earnings claims, practices emotional sales pitch targeting financially unsophisticated individuals to join as distributors, and it has a history of lawsuits involving business and practices.

Last year, the Commercial Court in Belgium ruled that Herbalife’s sales method is a pyramid scheme, which is a violation of the article 91, 14° and 99 of the Market Practices Act. The court ordered Herbalife to end its sales practices in Belgium and to pay a penalty of €5,000 for every violation. The case was filed by Test-Aankoop, a non-profit consumer organization in Belgium. Herbalife filed an appeal on the case.

Furthermore, Ackman pointed out, the company’s business operations in every market experienced a “pop and drop.” Herbalife’s business peaked within the first couple or three years in every market and the following years its business declined. He believed that the company is running out of growth opportunities.

Ackman is confident that Herbalife is a pyramid scheme and it is causing enormous harm worldwide. Since 1980, Ackman’s firm estimated that approximately 1.9 million sales leaders failed in Herbalife business opportunity. Its failure rate is ~90 percent.

Herbalife’s Defense Against Ackman

Herbalife said Ackman’s presentation against the company is “outdated, distorted, and inaccurate.” According to the company, its management and board constantly review its business model and products, hires independent experts to ensure its full compliance with laws and regulations. The company also scheduled an analyst and investor day on January 10, 2013 to discuss and provide a comprehensive response regarding its business model.

According to Wall Street Journal, the company increased its $50 million quarterly stock buyback and it is seeking legal advice from Boies, Schiller & Flexner LLP; a law firm expert in complex corporate litigation.  

The company needs a strong defense against Ackman's accusation because his presentation is detailed and compelling. There is a possibility for Herbalife to collapse. Once a company is reported or rumored a pyramid scheme, people avoid it especially if does not have popular brands.

MarieCabural has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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